Black-Scholes
One of a wide family of
mathematical models that are used today in
finance to determine the so-called
fair value of
options contracts.
An options contract - be it a
call or a
put, of the
American or
European variety - is a very simple example of what is more commonly known as a
derivative; that is, a
financial instrument that has no value on its own, instead it
derives its value from another,
underlying instrument.
The so-called
Black-Scholes model, originally developed in 1973, is intended to allow traders and
investors to calculate the fair value of an options contract. It was considered
earth breaking (and in fact led to a Nobel Prize) since this problem
(the valuation of options) had been attempted by various parties since the turn of the century.
It wasn't until the
differential equations underlying the problem were recognized to be similar to the well known
heat transfer problem from
physics that sufficient progress was made.
In its basic form the Black-Scholes differential equation is able to value American and European options on
non-dividend paying stocks.
During the intervening years since it's introduction, it has been
extended to value other underlying instrument; for example,
stock market indices (e.g., the Dow Jones Industrials, or the S&P 500) or various
commodities.